A popular and, if used appropriately, helpful way of estimating a privately held company's fair market value is to use a comparable publicly traded company's market multiple of value (i.e., price to earnings ratio, or the price of a stock divided by earnings per share). However, small business owners must be careful not to simply assume that their firms are worth the same multiple of net earnings as that of a larger, publicly traded firm.Simply put, just because your firm manufacturers machine parts does not mean that its fair market value is the same as that of Eaton Corp.The business owner must be careful when an adviser suggests that the fair market value of his or her company can be best estimated by using the current average multiples of value derived from a comparable peer group of publicly traded companies. This methodology requires that you first identify a group of four to eight publicly traded firms that are in a similar industry to that of the privately held firm. Secondly, you calculate the current average multiple of values (market capitalization/revenues, market capitalization/EBITDA, market capitalization/net income, etc.) that these comparable firms trade at as a group. Finally, you use these comparable multiples of value and the target company's financial results (revenues, EBITDA, net income, etc.) to estimate a fair market value of the target company.This valuation methodology only can produce meaningful results if the adviser makes adjustments for: 1) the difference in the liquidity of publicly traded stocks versus privately held stocks, 2) the comparability differences between large and small firms, and 3) the change-of-control premium inherent in all change-of-control acquisitions.Publicly traded stocks can be converted into cash at a known value in a quick and inexpensive manner. Privately held stock cannot. Academic studies reveal that the difference in fair market value between liquid and illiquid equity securities ranges from 20% to 70%. Consequently, a lack of liquidity discount must be considered.Markets value large companies at much higher multiples of value than they do smaller companies within the same industry (think real estate value between small towns and large towns). Accordingly, a lack of comparability discount must be considered.Publicly traded securities trade on a minority interest basis. The owner of one share of IBM does not have an impact on the day-to-day operations of IBM. This is why most acquirers are forced to pay a premium above the fair market value in order to induce the owners of a publicly traded company to sell. Research reveals that this control premium averages between 25% and 45% for most industries. Consequently, a premium for change of control must be considered.Bottom line: The owner and adviser who use the peer group of comparable publicly traded companies methodology and do not consider the above three adjustments risk entering the mergers and acquisitions market with unrealistic expectations and a sales price that will not attract buyers.

Morning Roundup

Business headlines from Crain's Cleveland Business and other Ohio newspapers — delivered FREE to your inbox every morning. Sign up for the Morning Newsletter.